Over the past eighteen months, oil prices have more than doubled,
inflicting huge costs on the global economy. Strong global demand,
owing to emerging economies like China, has undoubtedly fueled some of
the price increase. But the scale of the price spike exceeds normal
demand and supply factors, pointing to the role of speculationâ€”and
underscoring the need for policy action to clean up the oil market.

Reflecting their faith in markets, most economists dismiss the idea
that speculation is responsible for the price rise. If speculation were
really the cause, they argue, there should be an increase in oil
inventories, because higher prices would reduce consumption, forcing
speculators to accumulate oil. The fact that inventories have not risen
supposedly exonerates oil speculators.

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But the picture is far more complicated, because oil demand is
extremely price insensitive. In the short run, it is technically
difficult to adjust consumption. For instance, the fuel efficiency of
every automobile and truck is fixed, and most travel is
nondiscretionary. Though higher airline ticket prices may reduce
purchases, airlines reduce oil consumption only when they cancel
flights.

This illustrates a fundamental point: In the short run, reduced
economic activity is the principle way of lowering oil demand. Thus,
absent a recession, demand has remained largely unchanged over the past
year.

Moreover, it is relatively easy to postpone lowering oil
consumption. Consumers can reduce spending on other discretionary items
and use the savings to pay higher gasoline prices. Credit can also
temporarily fill consumer budget gaps. Although the housing boom in the
United Statesâ€”which helped in this regardâ€”ended in 2006, consumer debt
continues to grow, and America's Federal Reserve has been doing
everything it can to encourage this. Consequently, for the time being
the U.S. economy has been able to pay the oil tax imposed by
speculators.

Unfortunately, proving that speculation is responsible for rising
prices is difficult, because speculation tends to occur during booms,
so that price increases easily masquerade as a reflection of economic
fundamentals. But, contrary to economists' claims, oil inventories do
reveal a footprint of speculation. Inventories are actually at
historically normal levels and 10 percent higher than five years ago.
Furthermore, with oil prices up so much, inventories should have
fallen, owing to strong incentives to reduce holdings. Meanwhile, the Wall Street Journal has reported that financial firms are increasingly involved in leasing oil storage capacity.

The root problem is that financial markets can now mobilize tens of
billions of dollars for speculative purposes. This has enabled traders
collectively to hit upon a strategy of buying oil and quickly
re-selling it when end users accommodate higher pricesâ€”a situation that
has been aggravated by the Bush administration, which has persistently
added oil supplies to the U.S. strategic reserve, further inflating
demand and providing additional storage capacity.

Absent a change in trader beliefs, the current oil price spike will
be broken only by a recession that exhausts consumers' capacity to
buffer higher prices, or when the slow process of substitution away
from oil kicks in. Thus, economic fundamentals will eventually trump
speculation, but in the meantime society will have paid a high price.

Whereas oil speculators have gained, both the U.S. and global
economies have suffered and been pushed closer to recession. In the
case of the United States, heavy dependence on imported oil has
worsened the trade deficit and further weakened the dollar.

This sobering picture calls for new licensing regulations limiting
oil-market participation, limits on permissible trading positions, and
high margin requirements where feasible. Sadly, given the conventional
economic wisdom, implementing such measures will be an uphill struggle.

But some unilateral populist action is possible. A major form of
gasoline storage is the tanks in cars. If people would stop filling up
and instead make do with half a tank, they would immediately lower
gasoline demand. Given lack of storage capacity, this could quickly
lower prices and burn speculators.